European Stance on Negotiations With Greek Bondholders Show Leaders Have More Steel Than U.S. Fed

A man passes in front of a huge replica of a one drachma coin in Athens. European leaders have been pushing Greek debtholders to accept cuts of over 50%. Photo: Reuters

When in Rome... do as the Germans tell you.

That corruption of the ancient maxim seems to describe the current state of negotiations between European Union leadership and the creditors holding the much-beleaguered Greek sovereign debt. The arbitration, while the subject of maddeningly complex discussions between fixed-income bankers, investors, supra-national bureaucrats and political leaders at the highest levels, basically boils down to how much of a loss investors in bonds of the Hellenic Republic are willing to take. Or more precisely, how much they are willing to lose now in exchange for not having to lose much more deeper into the future.

It's a situation commonly known in finance as taking a haircut, and happens, for example, when the debt holders of a suddenly-bankrupted company have to accept pennies on the dollar for bonds they had hoped to redeem many years down the line. The question, as with any haircut, is whether the barber is just trimming off some split ends or going for the full Sinead O'Connor treatment.

Enter Angela Merkel, or as some sovereign debt investors might be calling her, the Demon Barber of Scheidemannstrasse. Merkel, the German chancellor, comes into the negotiations balancing her gigantic profit-killing scissors while walking a tightrope. On the one hand, she is representing the interests of her German Federal Republic, whose industrious people are widely expected to pick up the bulk of the bill for any kind of bailout that saves the Greeks and their creditors from their reckless financial ways. On the other hand, she is representing the interests of her German Federal Republic, whose industrious people would suffer from crushing unemployment and a liquidity crisis if the Greek government were to default on its loans and whose industrious German banks (many of whom are the very debt holders she's negotiating with) would likely cease to exist if that happened.

She's wielded those scissors with considerable gusto, telling lawmakers in Berlin she would aim for a settlement that slashed more than 50% of the value of the bonds, more likely than not by replacing the toxic status Greek bonds with less than half in equivalent value of ironclad European Union bonds. Her position has been to give bondholders a 'take-it-or-take-it' offer. Her counterpart, the Rome-based Institute of International Finance, which represents the interest of the debtholders and had already made an agreement to take a 21 percent writedown in July, has said that position is untenable, setting a settlement of anything less than 60 cents on the dollar as unacceptable. It has also said that, if forced, the individual investors it represents reserve the right to demand full payment on the bonds by calling on various counterparties to make good on the credit-default swaps that insure the bonds.

There are limits ... to what could be considered as voluntary to the investor base and to broader market participants, Charles Dallar, head of the institute, said in a statement Tuesday. Any approach that is not based on co-operative discussions and involves unilateral actions would be tantamount to default.

Credit default swaps, for the few out there who might have stumbled upon this piece after not having read a financial news article in the past three years, are financial instruments, famously called weapons of mass destruction by Warren Buffett, that act as a kind of insurance without collateral on other financial instruments. Because the people offering the swaps don't have the collateral to cover the claims readily, and the unregulated nature of that market means no one knows exactly who's insuring what, an event where investors make many simultaneous claims (as the IIF is threatening) would result in a financial explosion that would make a the 1930s look like a firecracker by comparison.

As European leaders meet Wednesday to hash out the details on what their joint position should be for this and other plans to address the current crisis, differences have come to the fore on the haircut issue. France has maintained a position that any writedowns must be voluntary, siding with the investors on this point. Other countries, like Slovakia, have been downright aggressive towards debtholders.

On Wednesday, Slovakia's outgoing Prime Minister Iveta Radicova said investors' writedown has to be higher than 50 percent, according to The Associated Press.

There is a fear that negotiations might stall. Interestingly, this very difficulty in achieving a consensus decision, magnified by having to do so in a politically-charged public environment, will likely mean that the world leaders and banks will end up striking a fairer deal. Or at least a fairer deal than the ones seen before in similar scenarios.

The concept of a government entity taking toxic assets off investor's balance sheets and replacing them with high-rated ones is not new. Japan did it repeatedly during the 1990s and many of the programs instituted by the U.S. Federal Reserve since the financial crisis began in 2008 have followed a similar pattern. What is new is the concept of the government telling bankers the only fair solution includes them sitting on the barber's chair and standing still.

During the AIG bailout, then-head of the Federal Reserve Bank of New York Tim Geithner and Treasury Secretary Hank Paulson structured a bailout of the insurance giant that paid off holders of AIG bonds 100 cents on the dollar. And that was only the beginning.

Since then, The Ben Bernanke's Federal Reserve has engaged in various program of 'quantitative easing', essentially buying toxic waste mortgage-backed assets no one else wants and spending hundreds of billions to, by definition, overpay for those assets. The logistics behind the program have the most powerful central bank in the world giving debt holders U.S. government bonds (still the safest investment known to man in spite of the downgrade by Standard & Poor's earlier this summer) in exchange for trash. Two rounds of the easing have occurred and, according to a report from The Wall Street Journal out Wedneday, another one is being pushed by Federal Reserve Board Governor Daniel Tarullo.

The difference between Bernanke and Merkel? Who knows. Perhaps Bernanke is not a fan of the bald look.